When the Nifty touched an all-time high last week, Gurgaon-based Sumit Gupta opened his home loan account to check the outstanding amount. He had taken a 20-year loan of Rs 75 lakh in 2019, but reduced the tenure by five years when he prepaid Rs 10 lakh in March 2020. The money came from the Rs 15.5 lakh maturity proceeds of his PPF account. The remaining Rs 5.5 lakh invested in stocks has grown to around Rs 8 lakh and Gupta (see picture) is considering booking profits. "I think I should sell my stock investments now and use the money to prepay my home loan," he says.For many investor-cum-borrowers like Gupta, the current stock market rally is a good opportunity to book profits and bring down their outstanding debts. Prepayments can have a dramatic impact on the loan tenure. If Gupta pays off another Rs 8 lakh, his loan tenure will reduce further to a little over 10 years. In his case, the tenure has also come down due to the fall in interest rate in the past two years. 83865634 83865549Sumit Gupta, 41 GurgaonWhen his PPF account matured in March 2020, he used Rs 10 lakh of that amount to make partial prepayment of the Rs 75 lakh loan he had taken in 2019. That reduced his tenure from 19 years to 14 years. The remaining Rs 5.5 lakh of the PPF maturity amount was invested in stocks and has grown to Rs 8 lakh. He is now planning to withdraw from equities and prepay his loan. Prepayment of Rs 8 lakh will reduce his tenure by another 2 years and 2 months.Prepayment saves interestIn Vadodara, Divya Gadhvi Shah (see picture) does not wait for stock market rallies to reduce her debts. She has been aggressively paying down the home loan she took in 2014 when the interest rate was around 10%. "When I saw the repayment schedule, I was shocked to see that the interest outgo over 20 years was more than the principal amount," she says. That's when she decided to use surplus cash to pay down the home loan. In the past seven years, she has made several prepayments and twice got the loan converted to a lower rate. Shah's home loan will now end in 2024, 10 years earlier than its original tenure. 83865659Long-term borrowers like Shah are victims of reverse compounding. When you apply for a loan, it's tempting to go for the longest tenure because the EMI is lower. But a 20-year loan inflicts an enormous interest burden on the borrower. This is why financial planners advise their clients to go for as short a loan tenure as is possible. 83865579Divya Gadhvi Shah, 33, VadodaraTook a home loan of Rs 18 lakh in 2014 when the interest rate was around 10%. The original loan tenure was 20 years but when Shah realised that her interest outgo would be almost equal to the principal amount, she started to aggressively pay down the debt. In fi ve years, the outstanding amount was down to Rs 11 lakh and the tenure shortened by almost 8 years. The loan will now end in 2024, 10 years earlier than its original tenure.Sometimes, it may be necessary to go for a longer tenure. A young person with a low income won't be able to borrow enough if the tenure is 10 years. He will have to increase the tenure so that the EMI fits his pocket. For such borrowers, the best option is to increase the EMI amount every year in line with an increase in the income.Increasing the EMI amount can bring down the tenure dramatically (see graphic). This may not always be possible, given the pay cuts and income losses due to the economic slowdown and covid. But a 5% increase in the EMI every year will reduce the tenure by more than eight years. Increasing it by 10% every year would end the loan in less than 10 years. 83865813The prepayment approach will obviously not cut much ice with bullish investors who continue to expect the markets to do well. As Gupta's example has shown, had he invested the entire PPF maturity amount in stocks in March 2020, his Rs 15.5 lakh would have grown to more than Rs 22 lakh. But the market in March 2020 was very different from what it is right now. At that time, the market was in oversold territory with the Nifty trading below 9,000 at a PE of less than 20. Now the situation is different, with the market looking overbought and the Nifty within kissing distance of 16000 with a PE of over 29.Investors who enter equities at this stage should not expect the same returns in the coming years. In fact, there is a greater probability of losing money than making good gains over the next 1-2 years. Even if you don't lose money, the gains are likely to be muted.Prepay or investWe looked at the impact of prepayment on a Rs 50 lakh loan taken five years ago. A lump sum payment of Rs 10 lakh shaves off five years from the residual tenure of 15 years (see graphic). If the same amount was invested in stocks and equity funds and earned 12% returns, it would grow to a sizeable amount in 10 years. Whether this is possible in today's market is the question an investor needs to answer before he takes the decision to invest or prepay.Also, the investor must take into account that he would still have an outstanding loan of Rs 19.58 lakh at the end of 10 years. So, this amount will have to be reduced from the corpus to know the net gain for the individual. If your investment is earning less than 7% returns, you stand to gain more if you repay the loan.Not everybody may be able to make a lump sum prepayment. We also looked at a scenario where the investor increases the EMI after five years of starting the loan. Increasing the EMI by Rs 20,000 reduces the loan tenure by seven years from the residual tenure of 15 years. After eight years, the prepayer would be debt free while the investor will still have an outstanding debt of Rs 28.43 lakh. If the same amount was invested to earn 8% returns over the next eight years, the individual would still lose out. Only if one is lucky with investments over the next eight years will one be able to do better than the prepayer.Keep in mind that this calculation assumes that the home loan rate will remain static at 7%. The investor will lose more if the home loan rate moves up. On the other hand, the prepayer will lose out if the rate falls. Home loan rates are already quite low. As things stand, there is a greater likelihood of rates moving up than down from here.Good debt versus bad debtWe must clarify that our calculations do not take into account the tax benefits on home loans which reduce the effective rate of interest paid by the borrower. Under Section 24, interest of up to Rs 2 lakh paid on a home loan can be claimed as a deduction. But we have also not factored in the tax payable on gains from the investments.For some borrowers like Vivek and Sushmita Prakash (see picture), the tax benefit is quite helpful. The Bengaluru based couple has taken a joint home loan and both claim tax deduction of Rs 2 lakh each on the interest paid. "The interest rate of our home loan is 6.85% but the tax deduction in the 30% tax slab reduces this to less than 5%," says Vivek. 83865593Vivek 48, and Sushmita Prakash, 41 Bengaluru They took a joint home loan of Rs 65 lakh for 15 years in 2019. Though they have enough liquidity, the Prakashs don't want to prepay their loan because they consider it a good debt. The interest rate is very low at 6.85% and the tax benefits reduce the effective rate to just a little over 5%. Vivek recently prepaid a 8-year car loan in three years because the interest rate was higher at 9.25% with no tax benefits.Financial planners say individuals must distinguish between good and bad debt. Good debt are low cost borrowings that create assets which appreciate in value (like a house). On the other hand, bad debt is high cost borrowing for consumption (like a holiday) or purchasing depreciating assets (like a car). The Prakash understand this very well. Though he does not want to prepay his home loan, Vivek foreclosed a car loan last year. "The car loan was at 9.25% and offered no tax benefits," he says.
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